International Bond ETFs To Diversify Fixed Income Exposure

In recent years, one of the fastest-growing corners of the ETF market has been the fixed income space. As investors have become more comfortable with the idea of utilizing the ETF structure to achieve bond exposure, the number of products has multiplied and asset levels have surged. Ongoing innovation has brought increased granularity to the fixed income ETF space; a variety of funds now allow investors to target various maturities, credit qualities, and bond types in a single ticker. And investors have embraced these portfolio tools; since the beginning of 2009, more than $70 billion has flowed into fixed income ETFs.

The events of recent years have repeatedly highlighted the importance of fixed income exposure in a balanced, long-term portfolio. Bonds provided some degree of stability during the equity market collapses of 2009, and this asset class delivered impressive returns during the recovery effort as interest rates plunged.

Two of the most popular fixed income ETFs are the iShares Barclays Aggregate Bond ETF (AGG) and the Vanguard Total Bond Market ETF (BND), both of which seek to replicate the Barclays Capital U.S. Aggregate Bond Index and which together combine to hold over $20 billion in assets. These two ETFs offer investors broad exposure to the investment grade U.S. bond market, including government bonds, corporate bonds, and agency bonds across various maturities. But these ETFs, along with many of the products in the Total Bond Market ETFdb Category, include no international exposure.

In recent years, investors have shed their “home country bias” related to equity exposure, building larger allocations to international stocks in their portfolios. But the fixed income portion of many portfolios is still limited exclusively to U.S. securities, as investors have been slow to embrace the potential benefits of international diversification in this asset class. An all-U.S. equity portfolio would hardly be considered diversified, yet most investors don’t even consider international fixed income.

Foreign bonds often offer investors more robust yields than domestic fixed income securities, thanks to higher discount rates in numerous countries including Australia, the euro zone nations, and virtually any emerging market. Moreover, international bonds can add dollar diversification, potentially boosting returns when the currency winds are blowing against the dollar (as long as the debt is denominated in local currencies).

There are a variety of ETFs that can be effective tools for investors looking to expand fixed income portfolios beyond the U.S. borders. Below, we profile three of the most popular choices investors have in order to diversify their fixed income exposure geographically [see Why Emerging Market Bond ETFs Are Safer Than Developed Markets].

For investors who are worried about a surge in inflation thanks to massive intervention by the Fed, WIP could be an interesting addition. Much like the U.S.-focused TIP, WIP holds a basket of inflation-linked bonds. However, this ETF focuses in on notes issued outside of the U.S., allowing investors to protect part of their portfolio against inflation by utilizing foreign bond markets. The fund holds 74 securities in total and has a medium duration profile of close to 11.6 years. In terms of individual country exposure, bonds from the UK (17.9%) and France (16.7%) dominate, with sizable allocations going towards emerging market countries such as Mexico, Turkey, and Brazil as well. WIP–like many inflation-protected securities in the current environment—offers a relatively meager current income; the 30-Day SEC Yield is less than 1%. This is largely due to the high demand for inflation-protected securities, which has helped to send yields sharply lower and bid up the prices; WIP has gained about 8% over the last quarter alone [also see TIPS ETFs: Looking Beyond TIP].

For investors seeking to diversify their holdings out of U.S. dollars, ELD offers a compelling choice. One of the latest additions to the Emerging Markets Bond ETFdb Category, this actively managed ETFs seeks to deliver a high level of total returns consisting of both income and capital appreciation. The fund attempts to achieve this objective through investment in local debt denominated in the currencies of emerging market countries. Four emerging markets each make up just over 11% of the fund’s total assets and occupy the top four spots in ELD’s individual country weightings. These countries–Indonesia, Brazil, Mexico, and Malaysia–are followed by three markets in the EMEA region–Turkey, Poland and South Africa–which all make up close to 7.5% of the total country exposure.

The fund has a relatively low weighted average until maturity at just 5.9 years and an effective duration of just 4.1 years. While this is likely to take a few basis points off of the yield, it allows the fund to be far less sensitive to interest rate changes. Currently, the fund charges an expense ratio of 55 basis points and pays out a relatively robust distribution yield of 4.7% [see Emerging Market ETFs: Seven Factors Every Investor Should Consider].

Corporate bonds are a critical component of any well diversified portfolio, but many investors focus in only on American companies for their exposure. PICB tracks the S&P International Corporate Bond Index, which measures the performance of investment-grade corporate bonds issued by non-U.S. issuers in the following currencies: Australian Dollar (AUD), British Pound (GBP), Canadian Dollar (CAD), Euro (EUR), Japanese Yen (JPY), Swiss Franc (CHF), Danish Krone (DKK), New Zealand Dollar (NZD), Norwegian Krone (NOK) and Swedish Krona (SEK). The fund is most exposed to the major European currencies, with close to half of the exposure coming from the euro and another 30% from the pound.

PICB holds 112 issues in total and pays out a 30-day dividend yield of 2.7%. The fund falls into the medium-term slice of the spectrum with an effective duration of 6.6 years and an average years to maturity of 8.4. Its top individual holdings include bonds from HSBC Holdings (5.9%), E.ON (5.1%), and France Telecom (4.4%), which all mature in the early part of the next decade and have at least an A- credit rating. Like most bond ETFs, this PowerShares fund has surged so far in 2010; since inception it is up more than 15% while charging investors an expense ratio of 50 basis points [also read Bond ETFs: 12 Stops Along The Risk/Return Spectrum].